Friday, November 7, 2014

Neo-Fisherian Nonsense

Figuring out the intuition behind John Cochrane's paper, to see what was really going on in his model, really drained me. Do I really have to wade through that Stephanie Schmidt-Grohe and Martin Uribe paper too, and reverse-engineer their result as well? I'm too old for this. Don't any of you young whippersnappers have an economic intuition? Do you all get snowed by every fancy-mathy paper that comes along?

If I’m wrong about this – let Stephen Williamson correct me but I thought he started down the neo-Fisherian train of thought because he realized that his (and others) prediction that Bernanke’s Quantitative Easing was not leading to hyperinflation. So when one’s model fails, turn to another model. And if one is somehow adverse to admitting Keynes got something right – come up with something that makes no sense. John Cochrane decides to weigh with a post I could spend all day making fun of:

At left is what we might call the pure neo-Fisherian view. Raise interest rates, and inflation will come. I guess there is a super-pure view which would say that expected inflation rises right away. But that's not necessary.

I’m sort of glad he laid this out and it makes my first take easier. This whole neo-Fisherian nonsense strikes me as turning Dornbusch overshooting on its head. Dornbusch would argue that an expansionary monetary policy pushed real interest rates down in the short-run with the excess aggregate demand slowly driving up inflation. The neo-Fisherites would have it raise real interest rates in the short-run. So how is this supposed to work? We get a reduction in aggregate demand which becomes inflationary? Nick isn’t the only one getting too old for this. To be fair to Cochrane, his later ramblings did include this:

In the standard view, a central bank would soon see inflation spiraling down, would quickly lower interest rates to push it back up again. Upside down, this might be a stylized view of the 1970s and 1980s.

This dog that did not bark has demolished a lot of macroeconomic beliefs: MV = PY. Sorry, we loved you. But when reserves go from $50 billion to $3 trillion and nothing at all happens to inflation -- or at most we're arguing about percentage points -- it has to go out the window.

Where to begin with this? Increases in the monetary base are not the same thing as an increase in the money supply – whether measured in terms of M1 or M2. Friedman and Schwartz noted that the Federal Reserve did increase the monetary base during the Great Depression but the money supply fell. Here the explosion in the monetary base during Quantitative Easing was met with a less than proportional rise in rise in the money supply. Taking the 7-year period from mid-2007 to mid-2014, nominal M2 rose by only 56.3%. OK – over the same period nominal GDP rose by a mere 20.36% with velocity falling from 1.99 to 1.54. But guess what – velocity fell during the Great Depression as well. Let’s take a few charts of this measure of velocity starting with the one provided by FRED. Does Cochrane see a stable velocity before the Great Recession? I don’t. John Mauldin apparently loves this Quantity Equation but notes:

let's look at the velocity of money for the last 108 years. Notice that the velocity of money fell during the Great Depression.

Velocity was 1.95 in 1918 but only 1.17 by 1932. Velocity’s variability over the Great Depression period was staggering. But once one realizes that velocity does not capture any agent’s behavior but is really nothing more than a silly definition, then why would any economist love it? Another observer of velocity during both the Great Recession and the Great Depression tried the following experiment:

Let's go back even further in time and look at another velocity of money using GDP and the annual St. Louis Adjusted Monetary Base ... instead of M2 …Notice that the drop in the velocity of money after the Great Recession is unprecedented....except, if you go all the way back to the Great Depression.

Call me an old fashion Keynesian if you will but I was never impressed with the Quantity Equation. And this neo-Fisherian nonsense strikes me as a waste of time.